Mar 2 2004

Lesson 8

By

John Kennes

International Monetary Economics

Feb 26 2004

• In a monetary union, the fiscal instrument assumes greater importance:– The only macroeconomic policy instrument left at the national

level– Its effectiveness is increased (see Mundell-fleming model).

• A substitute to transfers• Many questions regarding its effectiveness and use.

Fiscal Policy and the Stability Pact

Feb 26 2004

• The crucial role of private expectations– A deficit today but a debt tomorrow: who will pay?– A tax cut, but how permanent

• Slow implementation– Agreement within government– Agreement within parliment– Spending carried out by bureaucracy– Taxes not retroactive

• Result: countercyclical moves can become procyclical actions

Limits on effectiveness

Feb 26 2004

• Automatic stabilizers: – Tax receipts decline when the economy slows down, and

conversely– Welfare spendng rises when the economy slows down, and

conversely– No decision, so no lag: nicely countercyclical– Rule of thumb: deficit worsens by 0.5% of GDP when GDP

growth declines by 1%.

A Crucial Distinction: Automatic vs Discretionary

Feb 26 2004

Automatic Stabilizers

Feb 26 2004

• Discretionary actions: a voluntary decision to change tax rates or spending.

• Technically: a chnage in the structural budget balance

Discretionary

Feb 26 2004

– G=G(y) and T=T(y) with G’<0 and T’>0.– Actual budegt balance: B(y)=G(y)-T(y) with B’>0– Cyclical adjusted balance: B(yp)=T(yp)-G(yp)– So, roughly: B(y)=B(yp)+B’(yp)(y-yp)Discretionary actions: a

voluntary decision to change tax rates or spending.

The Structural Budget Balance: A Formal Presentation

Feb 26 2004

• Discretionary actions: A voluntary decision to change tax rates or spending.

• Technically: a change in the structural budget balance• But no automatic correction of deficits, so a problem

of discipline.

A Crucial Distinction: Automatic vs Discretionary

Feb 26 2004

• Yes, if national fiscal policies are a source of several externalities

• Income externalities via trade:– Important and strengthened by monetary union

Should the Instrument Be Subjected to Some Form of Collective Control?

Feb 26 2004

Income Spillovers 1972-2004

Feb 26 2004

• Yes, if national fiscal policies are a source of several externalities

• Income externalities via trade:– Important and strengthened by monetary union– A case for some coordination

• Borrowing cost externalities– One common interest rate– But euro area integrated in world financial markets

Should the Instrument Be Subjected to Some Form of Collective Control?

Feb 26 2004

• The track record of EU countries is not good

The Most Serious Concern: The Deficit Bias

Feb 26 2004

• Fiscal indiscipline in parts of the euro area might concern financial markets and– Raise borrowing costs: unlikely, markets can distinguish

among countries

• More serious is the risk of default in one member country– Capital outflows and a weak euro– Pressure on other governments to help out– Pressure on the eurosystem to help out

What is the Problem with the Deficit Bias?

Feb 26 2004

• The no-bailout clause– Overdraft facilities or any other type of credit facility with the

ECB or with the central banks of the Member States (herinafter referred to as ”national central banks”) in favour of Community institutions or bodies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the ECB or national central banks of debt instruments. (Art. 101)

The Answer to Default Risk: The No Bailout Clause

Feb 26 2004

• The no-bailout clause• Still, fears remain:

– Informal pressure– Impact on the euro

• Prevention is better, especially given a tradition of indiscipline

The Answer to Default Risk: The No Bailout Clause

Feb 26 2004

• The arguments for:– A serious externalties– A bad track record, anyway.

• The arguments against– The only remaining macroeconomic instrument– National governments know better the home scene

In the End, Should Fiscal Policy Independence be Limited?

Feb 26 2004

• Two general arguments for collective actions: – Externalities– Increasing returns

• Two general arguments against collective action– Heterogeneity of preferences– Information asymmetries

• And a caveat– Government may pursue own interests.

The General Principles

Feb 26 2004

• Distinction No. 1:– Micro/structural aspects (tax and spending levels and

structure)– Macro aspects (the balance between tax revenues and

spending)

• Distinction No. 2:– Coordination: voluntary and flexible efforts at taking into

accounts each other’s action– Binding commitments or rules

How to Restrain Fiscal Policies

Feb 26 2004

• Formally, the implementation of the Excessive Deficit Procedure (EDP) mandated by the Maastricht Treaty

• The EDP aims at preventing a relapse into fiscal indiscipline following entry into euro area

• The EDP makes permanent the 3% deficit and 60% debt ceilings and foresees fines.

• The Pact codifies and formalizes the EDP

The Stability and Growth Pact

Feb 26 2004

• Emphasis on the 3% deficit ceiling• Recognition that the balance budget worsens with

recessions:• Exceptional circumstances when GDP falls by 2% or

more: automatic suspension of the EDP• When GDP falls by more than 0.75% country may

apply for suspension• Precise procedure that goes from warnings to fining

How the Pact Works

Feb 26 2004

• When the 3% deficit ceiling is not respected:– The Commission submits a report to ECOFIN– ECOFIN decides whether the deficit is excessive– If so, ECOFIN issues recommendations with an associated

deadline– The country must then take corrective action– Failure to do so and return the deficit below 3% triggers a

recommendation by the Commision – ECOFIN decides whether to impose a fine– The whole procedure takes about 2 years.

The Procedure

Feb 26 2004

• The fine starts at 0.2% of GDP and rises by 0.1% of excessive deficit

The Fine Schedule

Feb 26 2004

• The sum is retained from payments from the EU to the country (CAP, Structural and Cohesion Funds).

• The fine is imposed every year when the deficit exceeds 3%

• The fine is initially considered as a deposit:– If the deficit is corrected within 2 years, the deposit is

returned– If it is not corrected within two years, the deposit is considered

a fine.

How is the Fine Levied

Feb 26 2004

• Emphasis on precuationary measures to avoid warnings and fines

• The stability programmes are embedded in the wider BERG, a peer monitoring process that includes the Lisbon strategy.

• Each year, each country presents its planned budget for the next three years, along with its growth assumptions.

• The Commission evaluates whether the submission is compatible with the Pact.

The Broad Economic Policy Guidelines

Feb 26 2004

• The BEPG shift the focus to ex ante commitments:– Led to the Irish warning (2001).

• Decisions are taken by ECOFIN, a political grouping:– France and Germany treated leniently in 2003-4

• Imposition of a fine can trigger deep resentment: – are fines credible?– If not, what is left?

Issues Raised by the Pact (1)

Feb 26 2004

• Does the Pact impose procyclical fiscal policies?– Budgets deterioriate during economic slowdowns– Reducing the deficit in a slow down may further deepen the

slowdown– A fine both worsens the deficit and has a procyclical effect.

• The solution: a budget close to balance or in surplus in normal years.

Issues Raised by the Pact (2)

Feb 26 2004

• What room left for fiscal policy: – If budget in balance in normal years, plenty of room left for

automatic stabilizers.

Issues Raised by the Pact (3)

Feb 26 2004

• What room left for fiscal policy: – If budget in balance in normal years, plenty of room left for

automatic stabilizers.– Some limited room left for discretionary action

Issues Raised by the Pact (3)

Feb 26 2004

• What room left for fiscal policy: – If budget in balance in normal years, plenty of room left for

automatic stabilizers.– Some limited room left for discretionary action

• In practice, the Pact encourages:– Aiming at surpluses– Giving up discretionary policy

• The earliest years are hardest– Takes time to bring budgets to surplus

Issues Raised by the Pact (3)

Feb 26 2004

The Early Years (Before Slowdown)

-6 -4 -2 0 2 4 6 8

Spain

Portugal

Netherlands

Luxembourg

Italy

Ireland

Greece

Germany

France

Finland

Belgium

Austria

2001 1998

Feb 26 2004

• Discipline imposed from outside– A further erosion of sovereignty

• Arbitrary limits– Why 3 %?– What about the debt ceiling of 60%?

• Asymmetry– The Pact binds in bad years only

• A budget forever close to balance or in surplus would drive debt/GDP ratio to 0.

Further Controversies